Bank M&A Clouded by Higher Deal Prices, D.C. Gridlock

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What bank M&A lacked in volume this quarter, it made up for in ambition.

There have only been 47 deals in the third quarter, which ends Monday. Banks announced 60 in the previous quarter and 48 in the first quarter. Unless a couple agreements pop up at the last minute, July through September will have been the slowest quarter for bank M&A since the fourth quarter of 2011.

That seems surprising considering several large and noteworthy combinations were announced this quarter, including MB Financial (MBFI) and Taylor Capital (TAYC) in the Chicago area; PacWest (PACW) and specialty lender CapitalSource (CSE); and Umpqua Holdings (UMPQ) and Sterling Financial (STSA), which would create the next Pacific-Northwest regional power.

Yet the average price of third-quarter deals was 146% of the target's tangible book value, according to data from Keefe, Bruyette & Woods. That's the highest average since onset of the economic downturn in 2008.

The increase in pricing is a watershed moment for M&A, observers say. Although volume was down, the pricing made the market look like one that is not weighed down with worries of things like toxic assets.

"The return to profitability at regional/community banks in 2010 brought with it a constant question: 'When will consolidation activity return to more normal levels?'" Terry McEvoy, an analyst at Oppenheimer, said in a Sept. 20 research note. "Following the string of deals in the sector since early summer the answer is finally 'now.'"

The increase in deal prices presents challenges, too. The disparity between what buyers are willing to pay and what sellers are willing to accept has widened, erasing some of the strides that the credit recovery has made in bridging that gap. It used to be that buyers discounted sellers because of embedded losses in the portfolio. Now, sellers are emboldened by what their brethren are fetching.

"The fourth-quarter announcements will be steady as it goes," says Ernest Panasci, a partner at Stinson Morrison Hecker in Denver. "People were expecting a higher volume and that would concur with the number of banks that are in discussion, but pricing is the single biggest issue."

Smaller community banks are not expecting that they can grab the 170% of tangible book that Sterling is getting, but the momentum is giving them hope that if they are being offered 120% today, 150% could be a year away, Panasci says.

The driver of the boost in pricing has been the positive market reaction to deals, McEvoy and others say. Investors have been blessing the buyers by ramping up their share prices in anticipation of deals and then pushing them further once a deal is announced so long as things like earnings accretion and tangible book dilution look suitable.

"That has been a change in sentiment," McEvoy says. "If I'm a bank CEO and I'm looking at how the market is treating buyers, I have more confidence to do a deal — and maybe pay a little bit more."

So, what's in store for the balance of the year? Others agreed with Panasci that the fourth quarter will resemble the rest of the year, putting 2013 on track to have roughly 200 deals announced.

However, Washington gridlock could put a damper on dealmaking, like in August 2011, when lawmakers battled over increasing the debt limit and the United States' credit rating was downgraded. The market fell and several negotiations were derailed or at least got more complicated.

On Friday the government was facing a potential shutdown within days, and the country will need to raise the debt ceiling again in October to pay its bills.

Predictions about the effect on M&A are mixed. Some observers say the protracted uncertainty in Washington has essentially become white noise to companies. However, given dealmaking's reliance on stock values, the market's reaction will be followed closely.

"Meaningful market swings could certainly affect M&A," says Stephen E. Nelson, managing director of investment banking for D.A. Davidson in Chicago. "It is just a nuisance. It is part of the discussion that most people are candidly tired of hearing."

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